It was in this hothouse period of
supply-side economics, September 1974, that the most important intellectual of
our time, Irving Kristol, invited me to lunch at the Italian Pavilion in
midtown Manhattan. Irving, who I’ve since come to call “Don Corleone,” the
godfather of neo-conservatism (and a lot more), was a professor of social
science (or some such) at NYU and also the editor of The Public
Interest quarterly.

At our lunch, Irving expressed dismay
that the newspapers were filled with articles about how the oil crisis was a
plot by the big oil companies, in league with the Arabs. He knew this was
foolishness, as I had been writing in the editorial columns of The Wall
Street Journal, and said he would like me to write an article for
Public Interest on the economic ignorance of the national press
corps. I replied that the problem was not with journalists, but with
economists, that the press corps simply operates as a medium of exchange
between the people and policymakers. It was the professional economists who
did not know what was going on and were providing the lame reasons that were
being reported on the front page on the major newspapers and on radio and
television.

Irving asked me if there were any
economists who knew the true reasons for the oil crisis and I said there were
only two that I knew of, Robert Mundell and Arthur Laffer, and that Mundell
had predicted the events when President Nixon left the gold standard,
informally in 1971, formally in 1973, the previous year. Whereupon Irving
asked if I could write an article about these two economists. Take up to
10,000 words, he said, and get it to him in six weeks and he would publish it
in the Spring 1975 issue. It was this article that came to the attention of
Ronald Reagan’s research team and eventually led to my writing "The Way the
World Works," which provided the intellectual underpinnings for the Gipper’s
1980 presidential campaign. In reading, you will especially note the relevance
today of the discussion 30 years ago on the balance of trade and balance of
payments.

This is the first of three
parts.

* * *

The Mundell-Laffer Hypothesis - A New View
of the World EconomyJude WanniskiThe Public
InterestNumber 39, Spring 1975

The United States has been passing
through an economic nightmare. It seems like just the other day -- and it was
-- that American economists of the first rank spoke confidently of
"fine-tuning" the economy to assure a predetermined rate of economic growth
within acceptable bounds of inflation and unemployment. And even those in the
profession who scoffed at the notion of such fine-tuning, those who argued it
could not be done in the fashion prescribed by the New Economics, were
prepared to assert that other strategies -- usually pertaining to the supply
of money -- could be called into play to keep the United States on the magic
path of non-inflationary growth.

Obviously, the profession has been
experiencing an intellectual crisis. Over a six-year period, the pragmatic
Republicanism of Richard Nixon shot into the twitching patient every antibody
the economic doctors of Cambridge and Chicago prepared. And always the vital
signs declined. Money was tightened and money was eased. Mr. Nixon became a
Keynesian and a "full-employment budget" was installed. Deficits were run on
purpose and deficits were run by accident. The Phillips curve, a wondrous
device by which politicians supposedly could balance unemployment and
inflation along a finely calibrated line, was enshrined in the textbooks. The
dollar was devalued and the gold window closed. The Japanese and Germans were
reviled as being stubborn, and worse, efficient. The dollar was devalued
again, then floated. Wages and prices were controlled through varied stages of
stringency, and a jawbone was brandished. At the end of all these exertions,
many are beginning to wonder whether the patient was sicker than had been
thought or whether the medicine has been making him sicker than he
was.

To be sure, the academic theoreticians
who pushed these various prescriptions will now all argue that their own brand
of medicine was not given time to work -- and besides, the patient was
poisoned by all those other medicines. They all have a point in that there is
rarely enough time in the real world to see a diagnosis and a prescription
through; politicians and the public will always want a remedy that doesn`t
require the patient to get much worse, for very long, before he gets better.
That is one of the inevitable political constraints on economic policy, as
distinct from economic theory.

But before one laments the constraints
that the body politic places on our economic physicians, it is worthwhile
seeking out another opinion. It is always possible there is an expert around
with a superior diagnosis of our economic illness -- one that does not require
politically impossible prescriptions. And, in fact, there are two such experts
around today: Robert A. Mundell, 42, a Canadian who is professor of economics
at Columbia University, and Arthur B. Laffer, 34, of the University of
Chicago`s graduate school of business. For the past several years, they have
attempted to effect what some would call a "Copernican revolution" in economic
policy. And, with every passing year, they are getting a somewhat more
respectful hearing from their fellow economists -- though, of course, theirs
is still very much a minority point of view.*

It is the purpose of this article to show
how the Mundell-Laffer “model" of the world economy works, and why its
implications are not politically unattractive -- i.e., would not involve a
period of suffering by the world`s population in order to achieve improvement.
The model is really quite simple and, except for its applications, is not even
particularly novel. It is just, as Laffer says, "that nobody`s thought much
about it this way for about 50 years or so."

One of the reasons the Mundell-Laffer
hypothesis is getting a respectful hearing these days is that it easily
explains phenomena that other theories can explain only with immense
difficulty and complication. Though they are not in the business of
forecasting, Mundell and Laffer`s predictions of what would happen as a result
of particular policy changes have held up astonishingly well these past years.
Laffer in 1971 said the U.S. dollar devaluation would not mean a turn from
deficit to surplus in the U.S. trade balance. There wasn`t one. In February
1973, when the dollar was devalued again, he said it would mean "runaway
inflation" in the United States. In January 1972 -- almost two years before
the Yom Kippur war -- Mundell said the price of oil, and then of other
commodities, would rise dramatically if the U.S. economic policy makers
proceeded to do what in fact they did. Later in the year, he said that if the
Western economies did what they in fact subsequently decided to do, there
would be increased world inflation, a general rise in interest rates, and an
accelerated use of the Eurodollar. In 1973, he bet an eminent U.S. economist
$1 that U.S. inflation would be far worse in 1974 than 1973, and another $1
that sometime in 1974 the price of gold would hit $200.

Maybe Mundell and Laffer were lucky --
right for the wrong reasons, as some may say. But it certainly would seem to
be worth the effort to understand their reasoning -- and, above all, to
understand their general view of the economic universe and what it is in this
view that fundamentally separates them from the great majority of their peers.
Their policy prescriptions - - which derive from a kind of synthesis of
Keynesian and classical economic thought -- make no sense unless one shares
their perspective on the economic universe. After all, Columbus would have
found it difficult to persuade Queen Isabella that sailing west to the Indies
was good policy if he had failed to convince her that the world was round, not
flat.

The world is a closed
economy

This is where they start: The world
economy is truly integrated and has been for a long time. The proposition
sounds reasonable enough, perhaps even trite. Yet while most other economists
accept the idea to a degree, the prevailing analytical approach to economic
problems and policy is based on a quite different notion: that the U.S.
economy is in large part independent of the economies of the rest of the
world, especially now that monetary policies are not linked through fixed
currency exchange rates. From this prevailing notion there follows the idea
that, insofar as the U.S. economy experiences fluctuations in rates of
inflation as the result of the economic policies of other governments, such
disturbances are limited in scope by the U.S. volume of trade with the rest of
the world. These disturbances must be small, the conventional wisdom argues,
because U.S. trade is so small in relation to the whole of the U.S. economy.
In 1971, when the dollar was devalued by 13 per cent, virtually the entire
economics profession in the United States calculated that, because U.S. trade
was only five per cent of GNP, the effect of the devaluation on the level of
U.S. prices would merely be 13 per cent of five, or a little more than a
half-point on the Consumer Price Index. This kind of calculation can be made
only by viewing the United States as a closed economy, "with international
relationships grafted on," says Laffer. But, they argue, the U.S. economy is
not a closed economy; nor is that of any other nation. The only closed economy
it makes sense to talk about is the world economy. One cannot understand the
American economy within an American perspective; it must be viewed from the
perspective of the world economy.

In simplest terms, what they are saying
is that prices are tied together around the world, not only by the volume of
goods shipped back and forth, but by rapid communication of price changes. To
verify this, one of Laffer`s students, Moon Hoe Lee, went to the trouble of
studying nine countries from 1900 to 1972. He found that (1) their general
price indexes indeed moved in step during the period, as long as their
exchange rates were unchanged; and (2) that when a country devalued or
revalued its currency, it experienced roughly equivalent amounts of inflation
or deflation. (The only brief exceptions were observed when a country became
isolated during wartime, Japan and Italy during World War II being the
clearest examples.) What this means is that if a country devalues by 13 per
cent against the rest of the world`s currencies, you could expect that it
would experience higher inflation than the rest of the world until its prices
had risen by 13 per cent more than those of the rest of the world. So far from
such a revision of exchange rates having only a minor effect -- via foreign
trade -- on the Consumer Price Index, it has an exactly proportioned effect
relative to the price level in the rest of the world.

This isn`t exactly a revolutionary idea
but, as Laffer says, it hasn`t been thought about for quite a while. Here`s J.
Lawrence Laughlin writing in 1903:

The action of the international
markets, with telegraphic quotations from every part of the world, precludes
the supposition that gold prices could in general remain on a higher level
in one country than another (cost of carriage apart), even for a brief time,
because, in order to gain the profits merchants would seize the opportunity
to send goods to the markets where prices are high.

Laughlin talks about gold, but implicit in his statement is
that apples are affected similarly. Say there are a million apples in a
country selling at 10 cents each, but that there exists an unqualified demand
for 1,000,001 apples. If the extra apple can`t be gotten from the rest of the
world at less than 11 cents, cost of carriage apart, the price of all apples
will rise to 11 cents. In this illustration, the volume of trade involved is
only one part in a million -- but price still changes by 10 per
cent.

Going a step further, Mundell has revived
the proposition, and Laffer has documented empirically, that money, like
apples and gold, is also subject to these international forces of supply and
demand. When, for example, there is an excess demand for money in the United
States relative to the rest of the world, we will import money and run a
balance of payments surplus -- i.e., more money will be coming into this
country than is going out. When there is an excess supply of money in the
United States, we will export money and run a balance of payments deficit.
This idea also has its roots in earlier centuries, but is still a minority
view among economists everywhere. Balance of payments deficits are thought to
represent not a market phenomenon but a structural problem -- i.e., "capital
flight" or "undercompetitiveness." Laffer has further demonstrated that when a
country`s growth rate accelerates relative to the rest of the world its
balance of trade worsens; and vice versa. (As a child grows, it consumes more
than it produces.) But such a deficit is not cause for alarm. What is then
happening is something perfectly natural. As long as its government does not
speed up its own money creation, the country will export bonds to pay for its
deficit in trade. All that is occurring is that the rest of the world has
decided the country in question, with its higher growth rate, is a good place
in which to invest. (Just as parents invest in their growing
children.)

This way of looking at deficits and
surpluses in one`s balance of payments and balance of trade is strikingly
different from the prevailing way, and has large implications for economic
policy. But more about that later.

Myths of
devaluation

While the above approximates the
Mundell-Laffer long-distance view of the economic universe, it is necessary to
move in closer and examine the terrain piece by piece before the direction of
policy becomes apparent. A most important thesis, again one that cuts against
the predominant thinking, is this: When money supplies and currency exchange
rates change, the terms of trade remain unchanged. Somewhere at the root of
our economic policies of the past several years lies exactly the opposite
assumption.

Put simply, what Mundell and Laffer say
is this: If a bushel of U.S. wheat can be traded for a bottle of Italian wine
when $1 equals 100 lire, then, even though the United States devalues the
dollar so that it is only equal to 80 lire, the bushel will still trade for
the bottle. There may be a temporary confusion, which economists call “money
illusion,” but it is only temporary. That is, the U.S. farmer may temporarily
accept 80 lire in payment for his wheat, because it still equals $1 -- and his
first interest is in dollars. But when he discovers that $1 is now worth only
four-fifths of the bottle, he will insist on getting $1.20 worth of lire so he
still gets the whole bottle. As a result, the dollar price of U.S. wheat goes
up by the full amount of the devaluation. Or the lire price of Italian wine
goes down.

It is thus the contention of Mundell and
Laffer, borne out by considerable empirical evidence, that devaluation has no
"real" effects, but results only in price inflation in the devaluing country
relative to the country or countries against which the devaluation occurs. By
reducing the amount of goods its money can buy, the devaluing country creates
an excess demand for its money. If it simply prints more money, there is no
balance of payments improvement -- which was what devaluation was supposed to
achieve. If it doesn`t, its citizens will simply import money (by exporting
bonds) to satisfy the excess demand, and this will show up as a brief
“improvement” in the balance of payments.

But isn`t it true, as the textbooks and
newspapers have been saying for a generation, that when a country devalues,
the goods become more expensive, so it buys fewer of them, while the goods
that foreigners buy, from it are cheaper, so the foreigners buy more of them?
And the net result is a nice improvement in the devaluing country`s balance of
trade? The answer is: No.

Laffer points out that by looking only at
what happens to the demand for imports in each country following a
devaluation, the textbooks see only half of what happens. What about the
demand for exports?

When the United States devalues its
currency, for example, the goods it exports fall in price in terms of foreign
currencies. Under normal supply and demand conditions, the residents of the
United States should then buy more of its export goods and have less incentive
to produce them. Abroad, the goods foreigners export to the United States rise
in price relative to U.S. currency. They should then have less incentive to
buy their own export goods and want to make more of them, increasing exports
to the devaluing country. This would mean the U.S. trade balance would worsen
in real terms if it devalued.

Here, Laffer is merely pointing out the
logical inconsistencies of the current theory; in fact, he argues, devaluation
only invites inflation and will not affect the trade balance. His empirical
study of 15 devaluations between 1961 and 1967 shows no relationship between
devaluation and improved trade balances. In most cases, trade deficits in fact
worsened in the years following a country’s devaluation simply by the law of
probability -- since there is no causal relationship -- trade balances should
improve half the time and worsen half the time.

“Most of Great Britain`s economic
problems over the last 30 years have come about because of London`s fetish
with the trade account,” says Mundell. “It is forever trying to increase
exports and decrease imports, and in the process of trying to send more goods
out and allow fewer in has systematically reduced the efficiency of its
economy.” It has also, of course, experienced massive inflation. West Germany,
on the other hand, has accepted a series of major currency appreciations that
should have doomed its trade balance. Yet its domestic economy remains
vigorous and its trade balance in surplus, and inflation has been very
moderate.

Endnotes:* There is no joint Mundell-Laffer paper. Mundell,
the prime mover, writes the theory. Laffer, more the empiricist, provides the
data support, contributing slices of theoretical inspiration along the
way.